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Credit Default Swaps Losses Estimated at $150 Billion

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A story on Bloomberg this morning uncharacteristically lacks a news hook but gives a good deal of color on counterparty risk in the credit default swaps market.

The story argues that the other shoe may finally drop in the $62 trillion CDS market due to rising junk bond defaults. We’ve long seen that market as a disaster in the making. With economic exposures estimated at 2% of notional amount, $1,2 trillion is at risk, making it larger than the subprime market. Thus the $150 billion in losses estimated by BNP Paribas analyst Andera Cicione is plausible.

From Bloomberg:

Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis….

The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.

“It is a Damocles sword waiting to fall,” says Soros,…“To allow a market of that size to develop without regulatory supervision is really unacceptable,” Soros says…..

The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist….

“The Fed’s fear was that they didn’t adequately monitor counterparty risk in credit-default swaps — so they had no idea of where to lend nor where significant lumpy exposures may lie,” he says.

Those counterparties include none other than JPMorgan itself, the largest seller and buyer of CDSs known to the Office of the Comptroller of the Currency, or OCC.

Note that Fed only has access to regulated bank CDS exposures, but not that of investment banks or hedge funds, both of which are significant protection writers. Hedge funds, for instance, are estimated to have written 31% in CDS protection. Back to Bloomberg:

The credit-default-swap market has been untested until now because there’s been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody’s Investors Service.

Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.

Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002….

A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader….

“This is going to complicate the financial crisis,” Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default – - this requires proving which bond or loan holders weren’t paid — and the amount of payments due.

“It’s going to become extremely messy,” he says. “I’m really scared this is going to freeze up the financial system.”

Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it’s only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.

“That’s a very conservative estimate,” he says, adding that his study finds that losses resulting from hedge funds that can’t pay their counterparties for defaults could exceed $150 billion…..

Cicione says banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That may not work, he says. Many of the funds won’t have the cash to meet the banks’ requests, he says.

Sellers of protection aren’t required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards, Cicione says…..

“I think there’s a major risk of counterparty default from hedge funds,” Cicione says. “It’s inconceivable that the Fed or any central bank will bail out the hedge funds. If you have a systemic crisis in the hedge fund industry, then of course their banks will take the hit.”

The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.

“It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,” the report said. “It can be difficult even to quantify the amount of risk that has been transferred.”

Counterparty risk can become complicated in a hurry, Das says. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle, Das says….

“It creates a huge concentration of risk,” Das says. “The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don’t think the regulators have the information that they need to work that out.”

And traders, even the banks that serve as dealers, don’t always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others.

More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company’s debt or collateralized debt obligations…

Banks send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, [hedge fund advisor Tim] Backshall says. For many investors, this system is a headache.

To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails, he says.

“It’s terribly primitive,” Backshall says. “The only way you and I could get a level of prices is searching for Ford in our inbox. This is no joke.”

In the past three years, at least two companies have developed software programs that automatically parse an investor’s incoming messages, yank out CDS prices and build them into real-time price displays.

The charts show the highest bids and lowest offering prices for hundreds of swaps. Backshall tracks prices he gets from banks using the new software….

BNP analyst Cicione says regulators will be hard-pressed to prevent the next potential breakdown in the swaps market.

“Apart from JPMorgan, there aren’t many other banks out there capable of doing this,” he says. “That’s what’s worrying us. If there were to be more Bear Stearnses, who would step in and give a helping hand? You can’t expect the Fed to run a broker, so someone has to take on assets and obligations.”

Banks have a vested interest in keeping the swaps market opaque, says Das, the former Citigroup banker. As dealers, the banks see a high volume of transactions, giving them an edge over other buyers and sellers.

“Dealers get higher profitability through lack of transparency,” Das says. “Since customers don’t necessarily know where the market is, you can charge them much wider margins.”

Banks try to balance the protection they’ve sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.

The idea for the banks is to make a profit on each trade and avoid taking on the swap’s risk.

“Dealers are just like bookies,” Kane says. “Bookies don’t want to bet on games. Bookies just want to balance their books. That’s why they’re called bookies.”….

Arturo Cifuentes, managing director of R.W. Pressprich & Co., a New York firm that trades derivatives, says he expects a rash of counterparty failures resulting in losses and lawsuits.

“There’s a high probability that many people who bought swap protection will wind up in court trying to get their payouts,” he says. “If things are collapsing left and right, people will use any trick they can.”

Frank Partnoy, a former derivatives trader and now a securities law professor at the University of San Diego School of Law, says it’s high time for the market to let in some sunshine.

“There should be a centralized pricing service for credit-default swaps,” he says. Companies should disclose their swaps holdings, he adds.

“For example, a bank might disclose the nature of its lending exposure based on its use of credit-default swaps as a hedge,” he says.

Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn’t worked. It’s been boycotted by banks, which prefer to continue their trading privately.

Leo Melamed, 76, chairman emeritus of Chicago Mercantile Exchange Holdings Inc., says there aren’t any easy solutions.

“Plus we’re not sure the banks want us to be in this business because they do make a good deal of money, and we might narrow the spreads considerably,” he says.

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  1. S

    Opco call today was just a nice little wakeup for the all is calm crowd. Not sure what to make of the ted spread contraction, other than a temporary reprieve. it has slowly been creeping down ever and that pace has accelerate since the front pager ion FT that the Fed was calling over to dealers who set the Libor price? Go figure. The Fed seems to be relying on the pavlovian habvit of the markets to search for under the lights. Whole they are doing that the ibanks are turning them out (dark pools, FT). all is not what it seems, for sure.

  2. ruetheday

    From what I have witnessed recently, I’d say that the Fed needs to do two things:

    1. Let the investment banks and hedge funds fail outright. No mercy.
    2. Protect the commercial banks under its oversight at all costs. Do not allow the banking system to fail or the money supply to collapse.

    All the while, be crystal clear about what is being done. Be crystal clear that it will be painful, but not fatal. Be crystal clear that it is necessary.

  3. macndub

    An ignorant question: how do we get from $62 trillion in notional CDSs outstanding to $1.2 trillion economic exposure? Could the right economic exposure be, say, $5 trillion just as easily?

    My apologies if this has been covered in a previous post.

  4. Yves Smith


    Not ignorant at all, and I was remiss in not providing a link, but may not be able to track it down soon.

    I am pretty sure it was in an IMF document, and you are correct, who knows? Whatever authority it was did not disclose its methodology, which means it may well have been based on dealer estimates (or the NPV of expected payments for protection, as in it is assumed the risk is efficiently priced).

  5. bobo7874


    The notional amount of swap contracts is increasing geometrically because counterparties usually terminate their economic exposure (purportedly) by entering into a second offsetting swap. Thus, if A and B are parties to a swap, and both want to exit, A enters an offsetting swap with C and B enters an offsetting swap with D, so after the 2 offsets, the system has gone from 1 swap to 3.

  6. urbandigs

    Macnudub – 2% of the $62 Trillion is what was states as the economic exposure.

    Since notional value of CDS is kind of like notional value of buying a call option, I guess it seems about right.

    For example, if I buy 10 call contracts for CSCO June 25 strike, at $1.20 a contract, it will cost me only $1,200, for the right to later purchase 1,000 shares (10 x 100s = 1,000 shares) of CSCO at $25, which would equal a notional value of $25,000.

    So, $1,200 is only 4.8% of notional value and my exposure on this trade. Man, haven’t done options in years, but I think I still have the concept down to answer your question. My small bet, can control a large position; this of course is a very small example.

    They are assuming $1.2 trillion is at stake for the buyers of CDS, I believe, while the notional value for issuers of this trade runs to 62 trillion. I assume the buyers of CDS, can only lose their initial bet. Is this correct? Anyone? Or am I way off here?

    Thx for any clarification.

  7. Francois

    Let me see if I got this straight.
    ““This is going to complicate the financial crisis,” Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default – - this requires proving which bond or loan holders weren’t paid — and the amount of payments due.

    “It’s going to become extremely messy,” he says. “I’m really scared this is going to freeze up the financial system.

    By all accounts, Das seems to be the real deal about derivatives. (I’m no expert far from it)

    My question: How can some people deemed as very smart can keep arguing that regulations are not necessary, even dangerous? Is this pure ideological blindness? Or is there something even bigger that I am missing here?

    I mean, the freezing up of the financial system is not exactly a desirable outcome for anyone, correct?

  8. Steve

    `Notional amount’ is meaningful for CDS in a way that it is not for interest rate swaps, for example. The fraction of the `notional amount’ at risk in a CDS is ~par minus recovery value so it can obviously be a very big number. With CDS the aggregate outstanding is `notional’ because it is a large multiple of the underlying issuance.

  9. bobo7874

    urbandigs: CDS are more like buying or writing puts (than calls), puts against the payments due under the debt. The notional amount can change, e.g., if the debt provides for contingent payments of principal or interest.

    francois: Prime brokers and banks make lots of money from having derivatives and other contracts not be traded on exchanges due to them having lots of information others don’t, and due to not having competition from the CME and NYSE, and due to increased trading volume from derivatives traders not being subject to various restrictions that exchanges impose on exchange traded contracts (eg, leverage).

    What will be interesting is if some hedge fund takes a huge position in CDS on some company and a much smaller position in actual debt of the company, but big enough to put it into involuntary bankruptcy and veto any viable plan of reorganization. Potentially, this could let someone with a small actual stake in a company hurt the company in order to make money from a much bigger notional position with respect to the company. If someone does this and blows up a company, non-financial corporate execs will raise a stink, and Congress or the SEC will come down hard on CDS.

    It’s somewhat like the hedge funds borrowing voting stock as a cheap way of getting voting power to help their activist positions. The press has started to pay attention to this strategy.

  10. bondinvestor

    we’ve seen this before. this is exactly what happened to Lloyds of London in the late 80′s / early 90′s. the “spiral”, as it came to be called, involved excess of loss reinsurance (LMX) and retrocessional reinsurance contracts (retro). syndicates in lloyds essentially could be divided into one of two types: those that ended up with imprudent concentrations of LMX exposures on their books, and those who didn’t have any such exposures. the former went bankrupt and the latter were merely wounded by the need to replenish the lloyds general fund (the reserve account that was meant to backstop individual syndicates if the names were bankrupted).

    there are many parallels between the LMX spiral and CDS. light/non-existent regulation. lack of stringent counter-party controls. bespoke, over the counter contracts. poor back office documentation. principal-agent asymmetries between management and investors. poor investor oversight. inadequate exposure modeling. a series of tail events that were thought to be statistically impossibilities. etc etc.

    the one big difference between the LMX spiral and the CDS market is that the names had unlimited liability, whereas financial institution debt & equity investors have limited liability. that, scarily enough, suggests to me that the CDS spiral could make the LMX spiral look like a walk in the park.

    for those of you who are unaware of what happened, here is it in a nutshell. thirty thousand names were personally bankrupted. the lloyds central fund was bankrupted. the city of london lost significant market share to bermuda, australia and other insurance markets that were not impacted by the losses generated by the spiral. and there was a big push to modernize the london regulatory framework and back office support. a system that has worked well for nearly 400 years had to be fundamentally re-designed due to the losses that were incurred during the spiral.

    interestingly enough, though, one thing didn’t happen. the market didn’t collapse. capital abhors a a vacuum and the prospect of supra-normal returns attracted huge amounts of capital to the global wholesale reinsurance markets. great fortunes were made by firms which avoided the bubble during the hard market that ran from 1990-1997.

    now, one big difference in this case is that the lloyds insurance market was not a repository for the national wealth of the UK in the same way that the US financial system arguably is.

    but i do think the case study is illuminating.

    and what’s fascinating is that so few people in the global markets are really aware of what happened. you can’t find a single book on amazon about it. and google references are non-existent. the knowledge is embedded in the minds of the thousands of brokers, underwriters and executives who lived through the crisis.

  11. macndub

    This is the whole issue, I guess. If you told me that a portfolio of options had $1 million of notional value, I couldn’t even begin to guess the economic value. If you’re long calls, then the risk is just the call premium. But somebody is short that call (he sold it to you), and that liability is infinite. (Yes, I know that the seller is delta hedged, but those hedges break down in discontinuous markets. Not that that ever happens, of course).

    Anyhoo, if this ends up being a circle jerk of bankruptcies in which only hedgies get hurt, meh. But I strongly suspect, er, not.

    I was just confused because I thought that somebody had come up with a reasonable valuation of CDSs at risk, which would be quite interesting.

    Regarding the obfuscation of an OTC market, this was the situation in some hydrocarbon commodity markets a decade ago. It corrected itself with the rise of more transparent reporting, greater regulation, and the rise of exchange-traded products (along with the required standardization of products). Transparency in CDSs would be harder, I guess, because each one is a one-off. As well as, lets face it, everyone needs motor gasoline, but almost nobody really, truly needs credit protection on some synthetic bond.

  12. Anonymous

    Righteo, bondinvestor, Lloyds’ market was not a repository for the national wealth of the UK. Instead it was a way to monetize the gentry’s illiquid assets by pledging their stately homes, art collections and wine cellars as collateral. So the collapse had the salutary effect of pushing their Gini coefficient toward equality. Also good deals on collectibles.

  13. bobo7874


    Don’t take too much comfort about CDS exposure being limited, as opposed to unlimited in the case of loss reinsurance. Lots of players have over 20 to 1 in actual leverage before taking into account leverage through their book of trades. Plus, it’s virtually guaranteed that a lot of purported hedges have significant missmatches. Like last year, some people were long ABX AAA, and short ABX BBB-, and got hammered when losses on their long position swamped gains on their short position. If you get one player crack up from a big missmatch in their purpotedly offsetting positions, that can cause some of their highly leveraged counterparties and lenders to also crack up.

  14. binaryoptions

    I thought CDS were being “marked-to-market” under those standardized contracts provided by the International Swaps and Derivatives Association. If so, then wouldn’t any per-transfer loss/gain in the value of the outstanding swap already have been settled, thus decreasing the notional?

  15. eh

    Be crystal clear that it is necessary.

    The government ought to do something similar with the GSEs — pump a judicious amount of capital in and then turn them loose. No more ‘implicit’ guarantee.

  16. derino

    bondinvestor – and of course the big similarity between Lloyds and this is the circularity of it all. Claims will just go round and round the system. The trigger for the Lloyds collapse were the claims from the Piper Alpha disaster, which came to about $1bn in total – big, but could have been easily absorbed by the market. Instead the excess of loss policies meant that the total of claims across the market was about $16bn, with the results you’ve described.

  17. Paul Amery

    Bond investor, I don’t understand your comment that the limited liability of the CDS counterparties vs. the unlimited liability of Lloyd’s names makes this crisis potentially worse (apart from the scale of the exposures now and then, of course) – please elaborate.

  18. Yves Smith


    To the extent that the contracts are standardized (and I understand the ones written a few years ago were not only non-standard, but even some were not juridically valid, and some are still outstanding) they are only in terms of contract boilerplate. They are NOT standardized in respect of their terms, they are customized.

  19. Richard Kline

    “Customers don’t necessarily know where the market is . . . .” *aaiiieeEEEEEE!*

    Bondinvestor, I’m with you: increasing recklessness from liability limitation is a big worry for me with hedgies. Remember, Meriwether got a second chance to lose his investor’s money. This is what the system learned, that no failure is too big to end your career.

    I do remember when Lloyd’s kissed a chainsaw. One reason why the financial system generally may have learned little from it was the unique internal structure of Lloyds.

  20. S


    What is the impact of catbonds — ICAP announced in reuslts it is moving mre aggressivily into this area – yet another securitized product only seems this is abject gambling.

    Also could you explain previous question on liability?

Comments are closed.